Discover Money Market Fund Alternatives

Physician's Money Digest, February29 2004, Volume 11, Issue 4

For months, the miniscule money market fund returns have been testing the patience of physician-investors. Many are giving up and moving some of the money into bonds, real estate investment trust stocks, high-dividend stocks, and even growth stocks in search of higher returns. However, doing so without thinking through the implications may involve some unpleasant risks. There are some relatively safe alternatives you may want to consider.

Your Perspective

In investing, you should maintain a long-term perspective. This isn't easy because the present and the recent past always loom so large that we tend to weigh them too heavily in making decisions. "This too shall pass" may be a good phrase to keep in mind when making investment decisions in difficult times.

If you have a good investment plan, then you either have a long-term strategy for the rate at which you move the money from money market funds into other assets, or the money in your money market fund is the part that you keep absolutely safe as a reserve. In either case, you should not be in a hurry to move into higher-risk investments just because money market returns are so low.

Remember that stocks that pay high dividends are still stocks and have a much higher risk than money market funds or even short-term bonds. They belong in the stock part of your portfolio and not the bond or money market parts. If your plan is to have 60% of your portfolio in stocks and you achieve that goal, then you can afford to load up on dividend-paying stocks only if you're willing to sell an equivalent amount of other stocks.

CDs and Bonds

There are no exact substitutes for money market funds, but short-term CDs or high-quality, short-term bonds are close substitutes. Unfortunately, neither is offering a much better return at this time. Short-term would be less than a 2-year maturity. These options are currently offering returns of about 1.5% to a little over 2% per year. To earn this return, you will be taking a slightly higher credit risk, although if you stay within certain CD limits, there is no credit risk. If you hold either CDs or high-quality bonds to maturity, you will almost certainly receive your principal back.

On the return side, it's a matter of opportunity cost. If interest rates go up in the near future, you won't be able to take advantage of them until your CDs or bonds mature. If you try to cash in CDs early, you pay a penalty. If you try to sell short-term bonds before maturity, you receive less than their worth. In either case, the loss will most likely wipe out any possible gain from reinvesting the money at the higher return.

Trying TIPS

Another alternative is buying Treasury inflation-protected securities (TIPS). These bonds pay a fixed coupon (ie, real return) plus the rate of inflation. Currently, the real return you can receive on 10-year TIPS is around 1.8%. If inflation over the next year is 2.5%, you will actually earn a return of 4.3%.

Note:

The advantage of TIPS is that if the interest rate goes up, part of it is likely to be because of higher inflation and, therefore, you can participate in any interest rate increase. Because these have 10-year maturities, if the real interest rate goes up, TIPS will lose some value. However, if you hold them until maturity, you receive back all of your principal.

TIPS are somewhat complex instruments. If you decide to move some of your money market assets into TIPS in search of higher returns, make sure you fully understand them first.

Chandan Sengupta is the author of The Only Proven Road to Investment Success (Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004). He teaches finance (investment, business valuation, etc) at the Fordham University Graduate School of Business and also consults with individuals on financial planning and investment management. He welcomes questions and comments at chandansen@aol.com.